Put in an executive nutshell, the revised IAS19 should have little, if any, noticeable effect upon the asset allocation in German pension plans.
However, asset allocation is changing and will continue to change in response to a number of inter-related developments. Asset allocation is driven initially by market movements, namely the shrinking equity allocation of recent years, and then reinforced by feedback mechanisms such as changes in investor risk aversion and in regulatory requirements. Recent past experience leads to ‘group-think’ and a tendency to shift asset allocation towards fighting the last war.
Two clear lagged responses to the equity market fallout are: the rise in popularity and weighting of hedge funds holding out the promise of absolute return, reduced volatility and low correlation; and the idea that pension obligations are bond-like and therefore best duration-matched by long-term bonds and interest-rate swaps. Liability structures are themselves in a permanent state of flux and will continue to evolve with changes, inter alia, in demographics, economic growth and inflation.
So what are the revisions to IAS19? The main amendment is essentially the introduction of an option to treat actuarial gains or losses in the same way as UK companies currently do under FRS17.
It should be noted that the amendment to IAS19, to be implemented by 2005, does not provide any increase in transparency over the previous version of IAS19. This is because:
FRS17 prescribes recognition of the net position of pension fund’s liabilities and assets at the reporting date on the face of the balance sheet. Unexpected movements in this net position NEVER show up in the sponsoring company’s operating cost. This may be interpreted by some as being a ‘fudge’.
In contrast, the old IAS19, like its US-counterpart FAS87, permits unexpected movements in a
pension fund’s net position of liabilities and assets to be spread over the future life-time of beneficiaries. Thus, unexpected movements in the net position are spread over future years’ operating cost. This is currently interpreted by some as being a ‘fudge.
Both FRS17 and the old IAS19 provide essentially the same information in the notes to the accounts, so that any analyst can reproduce results in accordance with FRS17 on the basis of information provided to him or her under the old IAS19. Financial analysts will thus have exactly the same information to hand as they had before the amendment.
The new IAS19 permits both approaches. It is expected that British companies will choose the FRS17 approach; others will choose the old IAS19 and still existing FAS 87 approach. The main disadvantage of the introduction of this option is to reduce the comparability of financial statements. It may be interpreted by some as a fudge.
German companies which apply IAS19 for the first time, either in the old or the new version, usually see an increase in their cost of capital over local GAAP because mark-to-market valuations cause the net pensions liability to become higher than under local GAAP, thus weakening equity. The revised IAS19 will have no comparable effect because the underlying volatility of a company’s earnings has not been changed by the optional approaches available under the revised IAS19. But this is only in respect of pensions. There are typically other balance sheet and earnings positions that would have exactly the reverse effect.
Pension costs are only one source of the volatility in corporate earnings which gives rise to a higher market sensitivity or beta and hence to higher costs of capital. Other sources of earnings cyclicality include operational gearing (fixed versus variable cost structures), financial gearing (short-, medium- and long-term debt) and all revenue influences (demand, competing suppliers, product substitution, and so on). Given that investors can adjust their own leverage to determine how much market risk they wish to assume, they are indifferent to the volatility of any particular company’s earnings so long as they get a commensurate return. There is no free lunch from holding equities in a pension plan but neither is there any penalty which would justify foregoing the benefits of asset diversification and the inflation protection provided by real assets.
How then might investors in Germany rationally respond to IAS19 in their asset allocation? Some insightful investors may elect to do nothing on the grounds that adjustments via the balance sheet are relatively painless and the impact on operating results of FRS17 versus old IAS19 is minimal. Some long-sighted investors will realise that (a Statement of) Investment Policy is a topic in need of urgent attention and they will start to put in place a long-term investment strategy worthy of the name.
Investors should carefully contemplate the roles of the main asset classes in funding pension plans. Bond immunisation has its attractions to reduce the accounting effects of unexpected variation in the net position of assets and liabilities. Investors must be careful not to jeopardise a commercially-sound and long-term approach to the funding of their true economic liabilities. Nominal bonds provide no long-term protection against inflation and their interest rate sensitivity could bring capital losses – even if your liabilities fall faster, who wants to lose yet more money?
Diversification across asset classes is important and some investors now have all their eggs in one bond basket. Recently we have been hearing bonds described as ‘risk-free’ and yet the bond baskets of most investors have become risk-seeking (corporate bonds, mortgage-backed securities, emerging debt and even high yield or junk bonds).
Most pension liabilities are in some shape or form inflation-adjusted: the investor is short a real asset. So asset allocation should include real assets such as inflation-linked bonds, equities, real estate and private equity. Many investors would be well advised to add equities to their portfolios (after market movements, regulatory and peer-group pressure have all reduced them) in order to re-establish the desired long-term strategic asset allocation commensurate with their liability structure. In most market crises, equities and bonds have been negatively correlated so this is the main plank of any diversification strategy.
Alternative investments are suitable for the very long-term investors who can afford to earn illiquidity premiums. Real estate and private equity do not have mark-to-market valuations and their very lack of transparency – leading to smoothing of volatility – becomes especially attractive under IAS19. Hedge funds are bound to become increasingly correlated with the risky asset in a crisis and pension investors may like to reflect upon the volatility of long/short strategies given that a pension surplus is itself just a long/short position.
What should pension plan sponsors be doing? The new IAS19 changes nothing material by way of the information available on pension funds, because most German companies will not choose to move to FRS17-type recognition. The best thing to do is to take a long hard look at the two sides of the pension coin, objectively and holistically. The sound old approach to funding pensions need not necessarily be thrown overboard.
First consider what form of future pension provision most suits the sponsor’s strategic compensation needs or cannot be changed from their current structure. Then consider what asset mix best suits the liabilities of the sponsor’s plan, taking into account his real risk appetite, stakeholders’ interests and the accounting repercussions. Accounting repercussions are not the only aspect of pensions.
Alfred Gohdes is managing partner, Heissmann Consultants, based in Wiesbaden
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